Natural Gas ETF: A high Demand Commodity, Is This a Wise Investment?

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Natural gas prices have risen steadily over the past months as post-pandemic demand kicked in and sent energy prices through the roof. A lot of investors are thinking about how to gain exposure to rising natural gas prices. Possibly the easiest way is through natural gas ETFs.

The price increases of crude oil have been frontline news for the most part. However, another energy commodity has also continued to rise, with even more spectacular volatility.

Source: TradingView

The chart above shows how the price of natural gas has skyrocketed from the beginning of the year. The orange line is the price of the nearest WTI crude oil futures contract, compared to the nearest futures contract for natural gas. 

So, what are natural gas ETFs, and how do they work? Let’s have a closer look at the ins and outs of natural gas ETFs. 

What Are Natural Gas ETFs?

Natural gas ETFs are exchange-traded funds that allow investors to gain exposure to the price fluctuations of natural gas. These funds can invest in natural gas either through exposure to the commodity itself or through stocks. The equity they buy would have a high percentage of its revenue from natural gas extraction or transportation. 

However, holding natural gas physically also requires storage space, with all the necessary security features, and tends to be expensive. Then the fund would also need to cover transportation operations and costs. Both aspects require sector expertise and knowledge, which are beyond the scope of most funds that invest in securities.

How Do Natural Gas ETFs Operate?

Excluding holding physical natural gas for the reasons mentioned above, natural gas ETFs have two ways of gaining exposure to the returns of natural gas. One way is through investing in stocks of companies that operate in the energy sector. 

Especially companies that generate some or a large percentage of their revenue through operating natural gas-driven businesses. The other way is through investing in natural gas futures contracts. 

Equity Natural Gas ETF

I find equities are perhaps not the most direct way to gain exposure to natural gas prices. True, if natural gas prices rise then extraction companies will benefit from higher prices. However, corporations have all sorts of other operational costs and issues which may detract an investor’s exposure to the commodity.

There are also very few companies that operate only in natural gas. This reduces your real exposure to the commodity and gives you exposure to other resources the company operates in. And of course, that also comes together with exposure to stocks, even for companies that are 100% natural gas operators.

Futures Backed Natural Gas ETF

Futures-backed natural gas ETFs are the most direct way to gain exposure to the returns of this energy resource. There are no other risks involved such as corporate risk or exposure to other businesses that the company may run. 

Maintaining exposure to natural gas with a futures contract is not a matter of a simple buy-and-hold strategy. Since futures contracts expire, funds need to manage their positions in natural gas futures regularly.

In the above case, the natural gas ETF buys a futures contract on a major exchange. However, the fund will not take delivery of the natural gas due to the issues mentioned above regarding holding natural gas physically.

Rather, when the current contract is close to expiry the natural gas ETF will sell the futures contract and buy another in the next delivery month. This procedure is known as rolling the contract over. The management of futures contracts in this way can generate extra yield or reduced returns.

Roll Yield

Buying and selling futures contracts just before expiry allows the fund to maintain its exposure to natural gas perpetually. However, it also creates roll yield, depending on whether the futures curve is in contango or backwardation this yield will be negative or positive.

A futures curve is the set of prices for each expiry date as you go further away from the current date. If the futures prices are continually rising compared to the spot price the curve is known as contango. 

This type of curve will likely create some negative yield as the fund must sell the current futures contract at a lower price than the contract that it buys with the next expiry date. 

A backwardation futures curve has prices that decline as the months progress compared to the spot price. In this case, rolling contracts over may produce some positive yield. As the fund will sell its current futures contract at a higher price than the one it buys with the next expiry date.

To clarify, if the spot price of natural gas is constantly rising the fund should have a positive performance. However, the performance of the fund may not match the performance of the spot price of natural gas due to the above feature.

Benefits of Futures Backed Natural Gas ETFs

• Easy, clean, and cheap way to gain exposure to natural gas.
• No exposure to corporate risk or ex-natural gas business operations.
• Investors can access the futures market and have their investments managed by professionals.
• No need to set up a futures account.
• High level of liquidity of the exchange-traded fund market, giving easy entry and exit of investments. 

3 Natural Gas ETFs

Let’s have a closer look at 3 natural gas ETFs. Their performance, past and recent, and general specifications of each fund. The order in which we will take a look is solely dictated by the size of the fund, determined by assets under management.

United States Natural Gas Fund LP (UNG: NYSEArca)

This is the largest of the natural gas ETFs that invests directly in natural gas rather than energy stocks. The fund currently has $439.94 million in assets under management. And has managed an eye-opening 140.75% total return YTD.

The fund’s inception date is April 2007, and the return from that date is negative 98.48%. Of course, this is not necessarily what the next 15 years may look like. But it doesn’t seem to me like an asset you should buy and forget about.

Source: YahooFinance

The expense ratio is one of the highest in the industry at 1.35%. However, considering its high volatility that may not be a particularly worrying issue. The 20-day volatility is 81.33%, and it doesn’t settle down much by looking at longer time frames. The 200-day volatility is still at 72.03%

As with most natural gas ETFs that invest in futures, they don’t need to keep all their cash in futures contracts. They need enough cash to service margin calls on their futures positions, and usually, the margin amount is a fraction of the value of the futures contract.

The table below shows at the time of writing they held 5,391 natural gas futures contracts, for a value of $485 million. But their cash reserve is only $184.2 million. The rest is invested in cash equivalent securities, which are easily liquidated if needed. However, these securities also pay interest even if they are small payments.

UNG Holding May 20, 2022

Source: USCF Investments

ProShares Ultra Bloomberg Natural Gas (BOIL: NYSEArca)

This natural gas ETF seeks to create returns that are twice the returns of the Bloomberg Natural Gas Subindex. As the fund is following the performance of an index with multiple contracts, its objective is not to match the spot price of natural gas exactly.

The above feature and the fact that it uses a leverage of 2 means that the returns of this fund should be substantially different from those of other funds which hold the nearest futures contract and make no use of leverage. The expense ratio for this fund is slightly lower than UNG, at 0.95%.

The fund has $213 million in assets under management. Its current holdings are all in one natural gas futures contract for a value of $410.3 million, while the AUM is all held in cash. So, no extra yield from any holdings in short-term bills. 

The volatility of this ETF is much higher than its peers, and very high in absolute terms also. Extra volatility is a result of 2 times leverage which amplifies all price swings and therefore returns. The 20-day volatility for this fund is 164.43%, and the 200-day volatility is 137.65%.

Source: YahooFinance

We can see in the above chart that YTD BOIL has returned a staggering 340.85%. This seems in line with the 2 times leverage plus a little extra due to the different strategy it may follow. As one would imagine the fund has had negative returns since inception, but surprisingly only down 44%.

United States 12 Month Natural Gas Fund (UNL: NYSEArca)

This natural gas ETF has net assets of 45.9 million under management, considerably smaller than the previous two. The small amount of AUM may be due to the strategy involved in this particular ETF. The table below shows the fund’s holdings as of March 23, 2022.

Source: USCF Investments

The fund invests in the nearest futures contract for natural gas, but also in the following 11 contracts, for a total of 12 months of exposure through the whole set. The idea of holding 12 consecutive futures contracts is to mitigate the negative effects of a contango futures curve.

Like the big sister fund, UNL also holds a large amount of cash in liquid short-term securities. Although small, these securities are fixed-income instruments and will pay interest. 

This ETF’s volatility is slightly lower than that of UNG, but we are still talking about big numbers. 20-day volatility is at 73.12%, while 200-day volatility is 57.71%.

Source: YahooFinance

The YTD for UNL is 127.76%, which is slightly lower than the bigger fund UNG that only holds the nearest futures contract and has a YTD of 140.75%. Whereas the yield since inception is slightly better for UNL at negative 64.18% compared to negative 98.48% for UNG.

The expense ratio of 0.90%.  is slightly lower than its big sister fund UNG, which by itself may be part of the reason why this fund has had a better historical performance compared to its sister fund. 

Regulation

None of the ETFs mentioned above are regulated under the Investment Company Act of 1940 and do not offer any of the protections that come with the 40s Act regulation. These funds should issue a schedule K-1 which you will need for your tax claim. Speak to your tax advisor for full information on holding these securities.

Conclusion

Investing in commodities can be highly speculative and very risky with large bouts of volatility. As we have seen, the volatility of these funds, in general, is very high. The BOIL ETF has even larger volatility due to the use of leverage.

Ultimately, as any seasoned investor knows, a portfolio should be as diversified as possible. So, adding very volatile securities to a well-diversified portfolio can reduce the overall volatility. The risk reduction comes from the low or sometimes negative correlation of returns between assets.

Adding cryptocurrencies, precious metals, and real estate products to your portfolio may reduce overall risk as their returns tend not to be correlated. Therefore, adding natural gas ETFs, even though they are risky products per se, may bring down the overall risk of your portfolio.

In either case, you can hold natural gas ETFs in Self-Directed IRAs, to take advantage of a tax-enhanced environment. Several companies offer professional and specialized solutions, you can read reviews on the top Self-Directed IRA companies here.